Mr. Chairman and Cochairman, members of the Commission, thank you for inviting me to testify on this important and timely topic. My name is Trevor Houser and I am a visiting fellow at the Peterson Institute for International Economics and Director of the Energy and Climate Practice at the Rhodium Group (RHG), an economic research firm based in New York. Last year the Peterson Institute, in partnership with the World Resources Institute, launched a multiyear initiative to examine the international economic, trade, and financial dimensions of energy and climate policy. It is a great pleasure to be able to share with the Commission our research on ways that the US economy can, as the title of this hearing suggests, be both climate friendly and competitive.

Following a decade during which the United States was largely absent from international efforts to combat global warming, the Obama administration and the 111th Congress have indicated that climate change is now a top policy priority. Yet as Washington looks to enact domestic climate legislation and reengage in international climate negotiations, the United States finds itself in the worst economic crisis in a generation, a crisis that is dominating public attention and constraining fiscal resources. In my comments today I will discuss how addressing climate change will shape future US economic competitiveness and how we can craft policy in a way that helps us emerge from the current economic crisis.

The Impact of Climate Policy on US Competitiveness

Before assessing the impact on US economic competitiveness of efforts to arrest global warming, it is important to remember that letting that warming continue unabated is not economically sustainable. Economists estimate that the cost of projected temperature increases under a business-as-usual scenario would run between 5 and 20 percent of global GDP by 2100 (Cline 2009 and Stern 2007). Arresting this process will require imposing a price for greenhouse gas (GHG) emissions, which will raise the cost of energy for US consumers and the cost of production for US industry. At an economy-wide level these cost increases are fairly modest, roughly 1–2 percent of GDP, and pale in comparison to the costs of doing nothing (Cline 1992 and Stern 2007). The cost of acting, however, will not be spread evenly. Households that rely on electricity generated from coal will experience larger cost increases than households powered by nuclear energy, renewable energy, and natural gas. And heavy industries that consume large quantities of energy will see their economics change more significantly than light manufacturing and services.

From an environmental standpoint, this is the intended outcome of legislation to reduce emissions. By raising the price of high-carbon products and sources of energy, market-based climate policy creates an incentive for investment in new technology and a move toward low-carbon alternatives. The impact of this transition on US economic competitiveness depends on our ability to:

Level the playing field for high-carbon industries: Ensure that imposing a price for carbon in the United States does not place American firms at an unfair disadvantage vis-à-vis international competitors.

Capture opportunities in low-carbon technology: Develop new products and services that help households and firms reduce energy demand and GHG emissions.

Reduce dependence on fossil fuel imports:Save some of the $450 billion that the United States spends purchasing petroleum from abroad each year.

Catalyze improvements in productivity: Turn an incentive for improving energy efficiency into an opportunity to invest in increased productivity more broadly.

As this hearing is primarily concerned with the impact of climate policy on carbon-intensive manufacturing, I will focus my comments on ways to ensure these firms are competing on a level playing field, particularly in light of the current financial crisis. It is important to keep in mind, however, that this is only one element of how the transition to a low-carbon economy will impact US competitiveness.

Tackling Climate Change in a Globalized World

Climate change is a global problem and requires a global solution. The international community recognized this from the outset, and in late 2007 in Bali, Indonesia, the 192 signatories to the UN Framework Convention on Climate Change agreed to negotiate a new global climate agreement to take effect in 2013. Renewed engagement by the United States, and a willingness on the part of large developing countries to follow US leadership with commitments of their own, has injected fresh optimism into international negotiations set to conclude in Copenhagen this December. Understanding the likely contours of a global deal on climate change is key to the design of domestic US climate policy in general, and the treatment of trade-exposed, carbon-intensive industries in particular.

There is an emerging consensus that to avoid the most catastrophic effects of a warming world, the international community will need to reduce emissions 50 percent below 1990 levels by 2050. The most economically efficient way to achieve these cuts would be through a uniform price for carbon world wide, either through a global carbon tax or cap-and-trade system. However, given differences in levels of economic development, historic responsibilities, and domestic politics, commitments to reduce emissions will vary by country. As part of the Bali Action Plan, developing countries agreed to take "nationally appropriate mitigation actions" as part of a global deal but not the same level of reductions as their rich-world peers (United Nations Framework Convention on Climate Change, 2007). Even among developed countries, commitment levels will likely vary. For the third phase of its emissions trading scheme, the European Union plans to reduce emissions 20 percent below 1990 levels by 2020, or 30 percent if a global agreement is reached. The Obama administration has committed to reducing emissions 14 percent below 2005 levels by 2020 (3 percent above 1990 levels).

Differences in commitment levels, and in the types of policies adopted to reduce emissions, mean that, at least for an interim period, carbon prices will vary, not just between the United States, China, and India, but between the United States, Europe, and Canada. From an environmental standpoint, this is just fine. Within the context of a global target of a 50 percent reduction by 2050, the international community has flexibility in how it chooses to share the burden and individual countries have flexibility in choosing which policy approach to take so long as the numbers add up at the end of the day. Indeed, given the magnitude of the challenge, both in reaching agreement between countries and passing legislation within countries, such flexibility will be critical in getting to a global deal. The resulting variation in carbon prices, however, will create competitive challenges for industries that compete internationally and for which energy is a major cost of production.

In Leveling the Carbon Playing Field: International Competition and US Climate Policy Design, my coauthors and I list industries fitting this description (Houser, Bradley, Werksman, Childs and Heilmayr, 2008). At the most aggregate level this includes ferrous metals (iron and steel), nonferrous metals (aluminum and copper), nonmetallic mineral products (cement and glass), basic chemicals, and paper (figure 1.). In the United States, these industries account for roughly 3 percent of economic output and 2 percent of employment. Petroleum refining, some mining, and certain types of textile manufacturing could also be included in the list. Resources for the Future recently conducted more-detailed analysis of the impact of climate policy on US manufacturing and identified a similar set of potentially vulnerable industries (Ho, Morgenstern, and Shih 2008).

Figure 1 US Industry exposure to climate costs based on energy intensity and imports as a share of consumption

Over time, differences in national carbon prices can be reconciled by linking domestic cap-and-trade systems to create a global carbon market or harmonizing domestic carbon taxes internationally with side payments to less-developed countries. The political consensus and supporting infrastructure required to move to a single global carbon price will likely take at least another decade to build. In the interim, it is important that countries that choose to take more aggressive steps to reduce emissions do not lose market-share, investment, and jobs in carbon-intensive industries as a result. This threat of "leakage" risks undermining political support for strong action on climate and erodes the effectiveness of that action if carbon-intensive industry moves abroad in search of lower-cost jurisdictions. Even more important is that the issue is handled in a way that is supportive of both international climate negotiations and the global trading system, on which both our economic and environmental hopes rely.

Policy Options to Prevent Leakage of Emissions, Jobs and Investment

Broadly defined, there are three possible approaches to ensure that trade-exposed, carbon-intensive industry competes on a level playing field during the transition to a global carbon price: cost containment mechanisms, trade measures, and international sectoral agreements. My colleagues at the World Resources Institute and I discuss these options in depth in Leveling the Carbon Playing Field. Below I offer a brief description of each approach and what is required for it to be effective.

Cost Containment

Cost containment mechanisms are policies that reduce the costs associated with domestic climate policy. For this approach to be effective in leveling the playing field for carbon-intensive manufacturing, both direct and indirect costs must be covered. Direct costs are those incurred through the purchase of emission allowances or payment of a carbon tax for the greenhouse gasses emitted directly from the factory. Indirect costs are any increases in electricity prices paid by the factory as a result of climate policy. To ensure that cost containment mechanisms protect jobs as well as investor value, financial support provided to a factory should only cover costs actually incurred producing goods. To meet environmental objectives, support should be structured in a way that encourages firms to invest in low-carbon technology. And to minimize the impact on government coffers, aid should only be provided to manufacturing industries that face legitimate risk of leakage.

Trade Measures

As opposed to cost containment mechanisms, which reduce costs for domestic producers, trade measures raise costs for foreign producers, by imposing a price for carbon at the border. In a world where carbon prices will differ between parties to an international climate agreement, trade measures would need to be applied to carbon-intensive imports from all countries to effectively level the playing field (see, for example, Neuhoff et al. 2008). As stated earlier, Europe is planning more aggressive cuts in emissions between 2012 and 2020 than the United States, which suggests higher carbon prices. At the same time, the European governments plan to offset those costs for trade-exposed industries by providing emission allowances for free. Developing countries may opt for a more command-and-control approach to reducing emissions rather than a cap-and-trade system or carbon tax. The United States could calculate the net effect of the trading partner's climate policy on production costs and adjust it at the border to bring it into line with domestic US costs. Alternatively the United States could simply apply the full US carbon price to imports from all countries and leave it to the exporting country to rebate their own domestic carbon costs. Either way, to ensure equitable treatment of imports and proper environmental incentives, border adjustments would need to be tailored to individual foreign producers given the wide variation in process and production methods within a particular industry.

It is important to note that what is described above is considerably different from the trade measures included in draft US climate legislation introduced in the 110th Congress. Title XIII of the Boxer-Lieberman-Warner Climate Security Act envisions trade measures as leverage that can be used to encourage countries to come to the climate negotiating table, rather than as a tool for preventing leakage between countries participating in a global agreement. There may be value in using trade as a stick to punish free-riders to a global deal (discussed below) but this should be seen as separate from policies aimed at leveling the playing field for carbon-intensive industry.

International Sectoral Agreements

While it is unlikely that the current round of international climate negotiations will result in a harmonized carbon price for the global economy as a whole, finding a common approach to trade-exposed industries holds more promise. International agreements covering sectors like steel, aluminum, and cement could come in the form of a technology standard, emission-intensity target, or harmonized carbon tax. To be effective, a sectoral agreement would need to include a large majority of global production, which for most carbon-intensive products is still a manageable number of countries (Bradley, Baumert, Childs, Herzog, and Pershing 2007). Sectoral agreements could either be integrated into economy-wide, cap-and-trade or carbon tax regimes (likely the case in developed countries) or serve as a stand-alone policy (as could be the case in developing countries).

The Bottom Line

Short of a global carbon tax or cap-and-trade system, well-designed international sectoral agreements would be the most effective means of reducing emissions from trade-exposed carbon-intensive industries. Most carbon-intensive goods are consumed in the country in which they were produced and achieving meaningful emissions reductions from these industries requires addressing goods produced for the domestic market as well as for export. Unfortunately, the term "international sectoral agreement" in climate circles is used to describe a wide range of policy approaches, many of which do little to address the issues associated with trade-exposed, carbon-intensive industries. Despite years of discussion, the international community has made little progress in defining and agreeing on a sectoral approach that would guard against emissions leakage or putting in place the infrastructure that would be required for its implementation. In my view, it is unlikely that sectoral agreements will emerge from Copenhagen as a viable alternative to domestic policy options, though I am optimistic about our ability to make progress on this issue down the road.

Trade measures have the potential to effectively prevent leakage, if well-targeted and equitably designed. If the United States imposed its domestic carbon price on qualifying imports from all countries based on the average carbon-intensity of the same product made in the United States, the risk of leakage would be considerably reduced. If Customs and Border Protection allowed foreign firms to demonstrate that they were less carbon intensive than the US average and have their border charge adjusted accordingly, the measure would ensure that foreign producers were treated no less favorably than their American counterparts. Yet as the United States would be the first to take such an approach on an issue as complex and contentious as climate change, doing so unilaterally could create considerable risks both for the global trading system and international climate negotiations (discussed below). Given that arresting climate change will require a multilateral response, the United States should seek a multilateral agreement on the imposition of trade measures before using them to address leakage. In a recent book from the Peterson Institute, Gary Hufbauer, Steve Charnovitz, and Jisun Kim outline the elements of a potential WTO code on climate-related trade measures that could guide their use as a tool to prevent leakage in a world of differing carbon prices in a way that supports climate negotiations and the trading system (Hufbauer, Charnovitz, and Kim 2009).

Given that a global price for carbon is still out of reach and international sectoral agreements or multilateral trade measures will still take time to negotiate, US policymakers should look to cost containment mechanisms as the best way to guard against leakage of emissions, investment, and jobs. This is the approach being taken in both Europe and Australia as they look forward to the post-2012 world. Representatives Jay Inslee (D-WA) and Mike Doyle (D-PA) have proposed a mechanism along these lines called Output-Based Rebating (OBR), which would create an incentive for carbon-intensive manufacturers to reduce emissions while preventing carbon costs from getting high enough to force industries to offshore production or lose market-share to foreign competitors. Approaches like this hold considerable promise as interim measures to address leakage concerns as we transition to multilaterally agreed border adjustments or international sectoral agreements and ultimately to a global price for carbon.

Trade as a Stick to Support a Global Climate Agreement?

The urgency with which we need to act to address climate change and the fact that anything short of a global approach will fail to meet the challenge has prompted US policymakers to look for leverage that can be used to compel other countries to join us at the climate negotiating table. It is important here to keep in mind that despite new-found interest in Washington in addressing climate change, we are late to the party and still have a lot of catching up to do. Europe has test-run an emissions trading scheme and adopted aggressive targets for the 2012 through 2020 period. Australia recently joined the Kyoto Protocol and is in the process of crafting its own domestic climate policy. And larger emerging economies like China, Brazil, and Mexico are taking significant action to curb their growth in emissions. That said, if the United States is going to pass binding domestic climate legislation to meet our end of the bargain, it is natural to want some insurance that actions from other countries will be enough to get us to our global target.

A number of bills introduced in the 110th Congress, including the Boxer-Lieberman-Warner Climate Security Act, saw trade as a potential stick to help compel other countries to sign on to an international agreement. The US consumer plays an important role in the global economy and a critical role in the growth of large developing countries. The Boxer-Lieberman-Warner bill would have imposed trade measures on countries that failed to take action to reduce emissions "comparable" to that in the United States. In deference to international climate negotiations, the authors of the bill tried to craft this comparability test in a way that allowed for differentiated action between developed and developing countries and appeared to exempt countries in compliance with a future international climate agreement to which the United States is a party. In deference to the WTO, the authors opted to simply impose a carbon price on imports from countries that failed the comparability test, rather than an outright sanction on all goods.

Unfortunately, a trade measure that is compatible with the principles of the WTO does not provide much leverage. While exports of labor-intensive goods like electronics, toys, and apparel are important sources of growth in emerging economies, exports of carbon-intensive goods like steel, aluminum, and cement are not. Most of the demand for those goods comes from developing countries themselves to feed the construction boom resulting from mass urbanization. China, for example, accounts for 38 percent of all steel production world wide. Yet only 12 percent of this is exported and less than 1 percent shows up in the United States. All carbon-intensive exports from China to the United States combined account for 0.1 percent of the Chinese GDP, not much of a stick in comparison to the cost of climate policy.

Broader trade sanctions, rather than adjustments based on the carbon-content of imports, could play a role in enforcing a global agreement, if agreed upon multilaterally and accompanied by a new WTO code along the lines called for by Hufbauer, Charnovitz, and Kim. Until then, there are a number of carrots we can use to help encourage other nations, developing countries in particular, to join in a global agreement. Providing access to low-carbon technology and financial support to help cover its higher cost will be key to eliciting firm commitments from many poorer nations. Europe has chosen to take on more aggressive targets if other countries join in a global deal, an approach the United States could choose to emulate. Washington could also think more broadly and offer to discuss providing countries like China and India with a greater voice in global economic governance if they agree to play a leadership role on global climate change.

Climate Change in the Context of the Financial Crisis

The Commission asked how the financial crisis "impacts the implementation of climate-friendly policies within the United States and among our major trading partners." First, it is important to point out that comprehensive US climate policy, if passed today, would not take effect until 2012 at the earliest, by which time our economy should be on firmer ground. The same goes for a new climate treaty, which would kick in after Kyoto Protocol commitments expire that same year. That said, the debate about climate change at both the domestic and international level is occurring in the midst of the worst economic crisis in a generation with concerns about employment trumping all else in both in the United States and abroad.

Near-term policies to stimulate economic growth and job creation can address climate policy goals as well. In a report published earlier this year, my colleagues Shashank Mohan, Robert Heilmayr, and I found that "green recovery" programs like household weatherization, renewable energy incentives, and technology R&D can both boost economic growth now and help offset the budget impact of current fiscal stimulus through energy cost savings down the road (Houser, Mohan, and Heilmayr 2009). The American Recovery and Reinvestment Act included roughly $100 billion in climate-friendly spending. These measures alone will not be enough to meet the climate challenge, but they will help reduce the cost of a comprehensive climate policy that will.

Crafting such policy in the midst of the current crisis can be useful in and of itself. Uncertainty about the health of the financial system has slowed the rate of new investment dramatically. In the energy sector this is compounded by uncertainty about future US climate legislation. Signaling clearly to markets the targets and timelines for US emissions reductions will help provide investors with the ability to start preparing today for a low-carbon economic future.

Finally, the international response to the financial crisis will help shape international negotiations to address the climate crisis. The G-20 group of developed and developing countries has emerged as the lead forum for orchestrating an international response to the economic crisis. At their meeting last November, G-20 leaders pledged to work together to combat the global recession through coordinated fiscal stimulus. Washington is not alone in looking to meet long-term energy and environmental goals while bolstering short-term economic growth. Japan and South Korea have both trumpeted their stimulus plans as "Green New Deals," China has earmarked much of its $586 billion in spending for energy and environmental projects, and the United Kingdom and Germany have followed suite.1

The G-20 will meet again in April to compare notes on the recovery effort and take stock of each country's plan of attack. Leaders will be looking to coordinate their respective stimulus packages to ensure the greatest economic bang for the buck. Given that this same group of countries will be tackling climate change later in the year—either in a small grouping like the Major Economies Process, or through the UN-led negotiations in Copenhagen—they would be wise to assess the cumulative effect of these efforts on global carbon dioxide emissions and work together to ensure that various green stimulus efforts complement each other as well as long-term emission-reduction goals.

Outside of specific green recovery programs, the international response to the global financial crisis overall, and to global economic imbalances in particular, will have a profound effect on the world's energy and environmental trajectory. This is particularly true in the case of the United States and China, without which a solution to either the economic or the climate crisis is not possible.2 The macroeconomic imbalance between the two countries that emerged over the past decade (excessive US consumption financed by excessive Chinese savings and investment) is reflected in the two countries' carbon footprints. American consumers purchased SUVs and McMansions on the back of cheap credit while Chinese industry overinvested in steel, cement, and aluminum production on the backs of Chinese household savings (Bergsten, Freeman, Lardy, and Mitchell 2008 and Lardy 2008). As a result, more than 70 percent of US CO2 emissions come from consumer-related activities while more than 70 percent of Chinese emissions come from industry (Rosen and Houser, 2007).

The current crisis is already unwinding some of these economic and environmental imbalances. At the close of 2008, US oil demand had fallen 6 percent as consumers tightened their belts, and electricity demand in China was down by 10 percent as energy-intensive industries cut production.3 A smart response to the crisis can perpetuate these trends. Future US consumption will be greener, and the cost of climate policy reduced, if US recovery efforts weatherize homes, upgrade the electricity grid, and help improve automotive fuel efficiency. If China takes advantage of the crisis to consolidate heavy industry, improve its energy efficiency, and free up investment capital for lighter manufacturing and services, then it will emerge from the crisis with a growth model that pollutes less and employs more.

Such efforts would help prime the pump for climate talks in Copenhagen and make it easier to reach a global deal. By rebalancing its economy away from carbon-intensive industry China would significantly cut CO2 emissions while boosting job creation and overall economic growth. This would also help address leakage concerns in the United States and Europe and enable the developed world to move more aggressively toward a low-carbon future.

Conclusion

It is critical that we get the economic issues right in crafting a domestic and international approach to climate change. Arresting global warming will be a multigenerational process requiring sustained political support. The lessons of trade liberalization teach us that generating and maintaining this support will require an understanding of and adequate preparation for the distributional effects climate policy will have on the US economy. This goes beyond ensuring that carbon-intensive industries are competing on a level playing field. Climate policy is designed to move consumers away from high-carbon goods and services toward low-carbon alternatives. That means that over time certain products and production methods will become obsolete while others will be created. Managing this transition fairly and ensuring that US firms and workers are positioned to take advantage of the economic upside climate policy offers will be key to its long term success.

At the international level, the transition to a low-carbon economy must account for the development needs of low-income countries and address the leakage concerns of advanced economies. No single country was the ability to solve this problem on its own or the leverage to force other countries to act if they do not see it as in their interest to do so. Given the multilateral nature of the challenge, it is both appropriate and encouraging that the CSCE has decided to take up this issue. Members of the OSCE account for roughly half of global emissions and well over half of US imports of carbon-intensive goods. A common approach to climate change between OSCE countries, and the role of trade in meeting climate goals, will help support a politically viable and environmentally meaningful global agreement.

Thank you for the opportunity to share our research with you and I look forward to your questions.

Cline, William R. 2009. "The Stakes in Limiting Climate Change." [pdf] Remarks at the Symposium on US Climate Action: A Global Economic Perspective, sponsored by the Center for Global Development, Grantham Research Institute, Peterson Institute for International Economics, and the World Resources Institute, Washington, DC, March 3, 2009.

Houser, Trevor, Shashank Mohan, and Robert Heilmayr, 2009. A Green Global Recovery? Assessing US Economic Stimulus and the Prospects for International Coordination. Washington: Peterson Institute for International Economics and World Resources Institute.